This chapter discusses theories related to mergers and tender offers. It covers various reasons why mergers may create value such as economies of scale, synergies from combining operations, and acquiring human/organizational capital. However, mergers may also be driven by agency problems and hubris. The chapter then examines models of the takeover process and frameworks for analyzing sources of value from M&As as well as potential gains/losses to target and acquiring firms.

1. - - - - - - - - Chapter 6 - - - - - - - -
Theories of Mergers and Tender Offers
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2. Basic Concepts
• Economies of scale — average costs
decline over a broad range of output
• Different from spreading fixed costs
over a larger number of units
• Mergers allow a reorganization of
production processes so that plant
scale may be increased to obtain
economies of scale
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3. • Economies of scope
• Organization capital
• Organization reputation
• Human capital resources
– Generic managerial capabilities
– Industry-specific managerial capabilities
– Nonmanagerial human capital
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4. Free-Rider Problem
• Problem of diffused, small shareholders
– Small shareholders may not expend
resources monitoring management
performance in a diffusely held corporation
– Shareholders simply free-ride on monitoring
efforts of other shareholders and share in
any resulting performance improvements of
the firm
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5. • Free-rider problem in mergers
– Small shareholders will not tender at any
offer price below the higher expected price
that should result from the merger
– Individual decision to accept or reject
tender offer does not affect success of the
offer
– If offer succeeds, they fully share in the
improvement brought by takeover
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6. • Possible solutions to free-rider problem
– Allow bidder to dilute value of nontendered
shares of the target firm after takeover
– Two-tier offer
– Make some shareholders pivotal in the
outcome of the bid (Bagnoli and Lipman,
1988)
– Tender offer from a large shareholder or an
outsider who had secretly accumulated a
large fraction of the equity
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7. Models of the Takeover
Process
• Economic — competition vs. market power
• Auction types — Dutch, English
• Forms of games
• Types of equilibria — pooling, separating,
sequential
• Types of bids — one, multiple
• Bidding theory — preemptive; successive
bids
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8. Framework
• Total gains for both target and acquirer
– Positive
• Efficiency improvement
• Synergy
• Increased market power
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9. – Zero
• Hubris
• Winner's curse
• Acquiring firm overpays
– Negative
• Agency problems
• Mistakes or bad fit
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10. • Gains to target — all empirical studies
show gains are positive
• Gains to acquirer
– Positive — efficiency, synergy, or market
power
– Negative — overpaying, hubris, agency
problems, or mistakes
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11. Sources of Value Increases
from M&As
• Efficiency increases
– Unequal managerial capabilities
– Better growth opportunities
– Critical mass
– Better utilization of fixed investments
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12. • Operating synergy
– Economies of scale
– Economies of scope
– Vertical integration economies
– Managerial economies
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13. • Diversification motives
– Demand for diversification by
managers/employees because they make
firm-specific investments
– Diversification for preservation of
organization capital
– Diversification for preservation of
reputational capital
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14. – Diversification and financial synergy
• Diversification can increase corporate debt
capacity, decrease present value of future tax
liabilities
• Diversification can decrease cash flow
variability following merger of firms with
imperfectly correlated cash flow streams
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15. – Diversification discount
• Studies find that the average diversified firm has
been worth less than a portfolio of comparable
single-segment firms
• Reasons
– External capital markets allocate resources more
efficiently than internal capital markets
– Rivalry between segments may result in subsidies to
underperforming divisions within a firm
– Managers of multiple activities are not well informed
about each segment
– Securities analysts may be less likely to follow multiple
segment firms
– Performance of managers of segments cannot be
adequately evaluated without external market measures
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16. • Financial synergies
– Complementarities between merging firms in
matching the availability of investment
opportunities and internal cash flows
– Lower cost of internal financing —
redeployment of capital from acquiring to
acquired firm's industry
– Increase in debt capacity which provides for
greater tax savings
– Economies of scale in flotation of new issues
and lower transaction costs of financing
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17. • Circumstances favoring merger over
internal growth
– Lack of opportunities for internal growth
• Lack of managerial capabilities and other
resources
• Potential excess capacity in industry
– Timing may be important — mergers can
achieve growth and development of new
areas more quickly
– Other firms may be competing for
investments in traditional product lines
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18. • Strategic realignme nts
– Acquire new management skills
– Less time to acquire requisite capabilities
for new growth opportunities or to meet
new competitive threats
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19. • The q-ratio
– Ratio of the market value of the firm's
securities to the replacement costs of its
assets
• High q-ratio reflects superior management
• Depressed stock prices or high replacement costs
of assets cause low q-ratios
– Undervaluation theory
• Acquiring firm (A) seeks to add capacity; implies
(A) has marginal q-ratio > 1
• More efficient for (A) to acquire other firms in
industry that have q-ratios < 1 than building a new
facility
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20. • Information
– New information generated during tender offer
process causes target firm share to be permanently
revalued upward even if offer is unsuccessful
– Two information hypotheses
• ”Sitting on a gold mine" — tender offer disseminates
information that target shares are undervalued
• ”Kick in the pants" — tender offer forces target firm
management to implement more efficient business
strategies
– Synergy explanation — upward revaluation in
unsuccessful offer merely reflects likelihood that
other bidders may surface with specialized
resources to apply to target
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21. • Signaling
– Information — an outside event not initiated
by the firm conveys information
– Signaling — particular actions by the firm
may convey other significant forms of
information, e.g., that management does not
tender at the premium price in a share
repurchase signals that the company's
shares are undervalued
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22. Winner's Curse and Hubris
• Winner's Curse: The winning bid in a
bidding contest for an object of
uncertain value will typically pay in
excess of its true value
• One cause of the winner's curse
phenomenon in M&As is hubris, defined
as overweening pride and excessive
optimism
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23. Agency Problems
• Agency problems arise when managers
own only fraction of the ownership
shares of the firm
– Managers may work less (shirk) and/or
overconsume perks
– Individual shareholders have little incentive
to monitor managers
– Dealing with agency problems give rise to
monitoring and controlling costs
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24. • Solutions to agency problem
– Organizational mechanisms
– Compensation arrangements tied to
performance
– Market mechanisms
• Market for managers
• External monitoring through stock market
• Takeovers — external control device of last
resort
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25. • Managerialism
– Mergers are a manifestation of agency
problems
– Managers are motivated to increase the size
of their firms because their compensation is
a function of firm size, sales, or total assets
– Theory may not be valid if managers'
compensation is based on profitability or
value increases
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26. Free Cash Flow Hypothesis
(FCFH)
Jensen (1986, 1988)
• Free cash flows (FCF) are cash flows in
excess of the amount needed to fund all
positive net present value projects
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27. • Payout of free cash flow to reduce
agency costs
– Reduces amount of resources under
control of managers
– Prevents managers from investing in
negative NPV projects
– Outside financing is subject to monitoring
by capital markets
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28. • Bonding mechanism
– Forces managers to pay out future cash
flows by debt creation without retention of
the proceeds of the issue
– Discipline to be efficient to meet debt
obligations
– Prevents unsound investments
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29. • Theory prediction
– Positive stock price reaction to unexpected
increases in payouts
– Increased tightness of constraints requiring
the payout of future FCF will result in positive
stock price reaction
– Predictions do not apply for
• Firms that had more profitable projects than cash
flows to fund them
• Growth firms
• If agency costs cannot be resolved
perfectly, takeovers can help reduce them
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30. • LBOs
– Bonding effects of high debt ratios
undertaken by LBOs cause increase in
share price
– Successful LBOs also involve a turnaround,
an improvement in the firm's performance
– Strong incentives provided by large
ownership stakes of managers
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31. Redistribution
• Gains to target shareholders represent
redistribution from other stakeholders
– Tax gains — redistribution from the government or
public at large
– Market position — mergers may increase market
power and redistribution from consumers
– Redistribution from bondholders — account for only a
small percentage of gains to shareholders
– Redistribution from labor — Is it forced recontracting
or is it recognition of changed industry conditions?
– Pension fund reversions — not a major source of
takeover gains
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32. Patterns of Restructuring in
the Chemical Industry
• Change forces
– Technological change
– Globalization of markets
– Favorable financial and economic
environments
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33. • Characteristics of the chemical industry
– U.S. chemical industry accounts for 2% of
U.S. GDP
– Diverse and complex
– Many distinctive segments; some overlap
with oil and other energy industries,
pharmaceutical and life science products
– Two major types of firms
• "All-around" companies operate in many areas
• "Focused" firms operate in downstream
specialized segments
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34. – Commoditization of products
– "Keystone" industry — building blocks at
every level of production in major industries
– Economic trends
• Chemical shipments not keeping up with growth
in economy
• Increase in service industries relative to major
users of chemicals has caused a decline in
growth of chemical shipments
– Easy entry
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35. • M&As in the chemical industry
– Chemical and related industries occupy
one of the top ranking areas in M&A
activity
– Include a wide range of adjustments and
adaptations to changing technologies,
changing markets, and changing
competitive thrusts
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36. – Roles of M&As
• Strengthen existing product line by adding
capabilities or extending geographic markets
• Add new product line
• Foreign acquisitions to obtain new capabilities
or needed presence in local markets
• Obtain key scientists for development of
particular R&D programs
• Reduce costs by eliminating duplicate activities
and shrinking capacity to improve sales to
capacity relationships
• Divest activities not performing well
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37. • Harvest successful operations in advance of
competitor programs to expand capacity and
output
• Round out product lines
• Strengthen distribution systems
• Move firm into new growth areas
• Attain critical mass required for effective
utilization of large investment outlays
• Create broader technology platforms
• Achieve vertical integration
• Revise and refresh strategic vision
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38. – Disadvantages of M &As
• Buyer may not have full information of acquired
assets
• Implementation may be difficult
– Considerable executive talent and time commitments
– Different organization cultures
– Wide use of joint ventures and strategic
alliances
• Combine different expertise and capabilities of
different companies
• Reduce size of investments and risks
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39. – Include changes in financial policies and
effectiveness
• Considerable use of highly leveraged
restructuring such as leveraged buyouts
(LBOs) and management buyouts (MBOs)
• Share repurchases
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40. • Concentration trends
– US chemical industry
• HHI in 1980 was 178, declined to 148 in 1990 and to
102 in 1998
• HHI is far below critical 1,000 specified in anti-trust
guidelines
• HHI has declined while M&A activity has increased
– Intense competition
– New entrants
– Reduced firm size inequalities
– New firms as a result of divestitures
– World chemical industry
• Significantly below critical 1,000 level
• HHI declining for the same reasons as in US market
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41. Measurement of Abnormal
Returns
• Residual analysis — tests whether
returns to common stock of individual
firms or groups of firms is greater or
less than that predicted by general
market relationships between return
and risk
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42. event window
C1 C2 m0 T1 t0 T2 t (time)
“clean” period
• Calculation of residuals
– Event period
“event”
• Identify event and its announcement day, t0
• Define event period from day T1 to T2 usually
centered on announcement date
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43. jt Rˆ
– Predicted (or normal) return, , for each
day t and for each firm j
• Represents return that would be expected
absent of event
• Estimated using "clean" period (C1 to C2) that
does not include event period
– Three methods
• Mean adjusted return
– Predicted return is mean of daily returns for firm j
during clean period
jt j Rˆ = R
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44. • Market model
– Predicted return for firm j in day t in event period
jt j mt Rˆ =aˆ +bˆ R
– Estimates for a and b are obtained from a regression
using returns during clean period
jt j j mt jt R =a +b R +e
– Takes explicit account of both risk associated with
market and mean returns
• Market adjusted return
– Predicted return is return on market index for that day
jt mt Rˆ = R
– Approximate market model where a = 0 and b = 1 for
all firms
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45. • Measures
– Residual
• Actual return minus predicted return
jt jt jt r = R - Rˆ
• Represents abnormal return — part of return that
was unexpected as a result of event
– Average residual returns
• Average across N firms for each event day t
r
å
=
N
AR j
jt
t
• Averaging across large number of firms mitigates
noisy component of returns
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46. – Cumulative average residuals (CAR)
• Cumulate average residual returns for
successive days over event period
T
2
å=
CAR =
AR
t t T
1
• Represents average total effect of event across
all firms over event period
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47. • Absolute gains and losses
– Absolute dollar gain or loss at time t due to
abnormal return during event period
W CAR MKTVAL0 t t D = ´
CARt = cumulative average residual returns (%)
to date t for firm
MKTVAL0 = market value of firm at date m0 previous
to event window interval
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48. • Statistical significance of event returns
– Test whether estimated cumulative average
residuals, CAR, is significantly different from
zero with a specified level of confidence
• Null hypothesis presumed true unless statistical
tests establish the contrary
H0: CAR = 0 (event does not affect returns)
• Alternative hypothesis
H1: CAR ¹ 0 (event does affect returns)
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49. – Test statistic is ratio of value of cumulative
average residuals, CAR, to its estimated
sample standard deviation
) CAR ( Sˆt-stat = CAR
– If absolute value of t-stat ratio is greater than
specified critical value, reject null hypothesis
with some degree of confidence
• |t-stat | > 1.96, CAR is significantly different from
zero at 5% level
• |t-stat | > 2.58, CAR is significantly different from
zero at 1% level
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